What is a Self-Directed IRA, and How Do They Work?

Some people want to play by their own rules, even when it comes to planning their retirement.

Should the same be true when choosing an IRA? Here’s a breakdown of what a self-directed IRA is as well as the pros and cons.

What’s an IRA?

An IRA (shorthand for Individual Retirement Account) is an investment tool used by people to save money for retirement. Basically, it’s a savings account with some major tax benefits and anyone can open one, depending on the type chosen–traditional or Roth.

Both traditional and Roth IRAs have yearly contribution limits of $6,000 ($7,000 if over age 50). It’s important to note that this limit is combined across all IRAs. Say you have a traditional IRA with one company and a Roth IRA with another; You can only contribute a total of $6,000, not $6,000 to each.

What’s a self-directed IRA?

If you’re using a brokerage firm to facilitate your IRA, your contributions are generally funneled into a basket of investments by your provider.

But with a self-directed IRA, on the other hand, your contributions are channelled into investments of your choosing. You’re in control–you have direction and make all of the investment decisions. Also, the key difference between a standard (traditional or Roth) IRA and a self-directed IRA has to do with the fund’s assets.

Normally, your IRA would contain common investment vehicles—stocks, bonds, mutual funds, etc. But if you have a self-directed IRA, a whole new world is open to you. You can invest in almost anything you want—private companies, real estate, or even racehorses.

Typically, when you sign up for a normal IRA (traditional or ROTH), a brokerage firm will build up your IRA’s holdings with a diversified mix of relatively safe investments. If you take it upon yourself, though, your fund’s fate (and level of diversification) is in your hands.

How do you open a self-directed IRA?

Want to gut it out and take control of your IRA? You’ll still need to use a brokerage firm to set it up and act as a custodian.

Once you find a custodial firm, you’ll open an IRA and start contributing. The custodian will hold your money and await your direction as to where to invest it. It will take a hands-off approach and won’t offer you advice.

Be aware, though, that if you do try to direct your own IRA, that there are considerable risks–even concerning your custodian.

There’s also the chance that you could break the rules, and if you do, the IRS could revoke your account’s IRA status. And hit you with a fee on top of that.

Ready to start planning for the future? Check out Intro to Retirement, our quick and easy-to-understand guide.